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Everything You Ever Wanted To Know About The Gold Standard

Throughout the ages, gold has captivated many cultures and societies. In our current post-gold-standard world, many feel that with the instability that occurred in the first decade of the 21st century, some form of the gold standard should be brought back. The gold standards implemented in the 19th and 20th centuries had inherent problems. Due to this rocky history, many people do not realize that gold, under the current free market system, is a currency.Gold has often been thought of in relation to the U.S. dollar, mainly because gold is usually priced in U.S. dollars, and there is a rough inverse correlation between the US$ and gold prices. These factors must be considered when we see that the price of gold is simply an exchange rate: In the same way one could exchange U.S. dollars for Japanese yen, a paper currency can also be exchanged for gold. (Learn more about the origins of currency. Read “The History Of Money: Currency Wars.”)

Gold is a Currency

Under a free market system, gold is a currency, although it is not often thought of as one. The price of gold will fluctuate relative to other forms of exchange, such as the U.S. dollar, the euro or the Japanese yen. Gold can be bought and stored, and while it is not often used as a direct payment method for everyday use, it is highly liquid and can be converted to cash in almost any currency with relative ease. (To learn about how gold rates are fixed, see “The Insiders Who Fix The Rates For Gold, Currency And LIBOR.”)

Gold, therefore, has tendencies like those of a currency. There are times when gold is likely to move higher and times when other currencies or asset classes are likely to outperform. Gold is likely to perform well when confidence in paper currencies is waning, when there is potential for war and/or when there is a lack of confidence in Wall Street-type trading instruments.

Silver and gold have been used in some capacity as currency since before the middle ages. The modern era of the gold standard began in Britain. In 1717 Isaac Newton, master of the Royal Mint at the time, overvalued the guinea (a coin minted in England between 1663 and 1814) in terms of its sterling value, and thus forced most of the silver out of circulation.

Wars within Europe and trade deficits also depleted silver reserves. Up until that point, silver and gold standards had both been in place, but by 1821, a gold-only standard was adopted. (You can read some of Newton’s official Royal Mint reports here.)

Silver was still used in coinage (along with gold) but by this time, the use of bank notes was increasing. By 1816, Bank of England notes were backed by a specific amount of gold.

As for the U.S., they began using a bi-metallic silver-gold standard upon passing the Coinage Act of 1792.Copper was also used in coinage, but was not convertible at specific rates like gold or silver. The goal was to use silver for small denominations and gold for large denominations, but this required a gold-to-silver ratio, which kept fluctuating based on market forces. The rate was fixed at 15 ounces of silver to one ounce of gold, with the market rate typically ranging between 15.5 and 16 to 1. Major gold discoveries starting in 1848 decreased the value of gold relative to silver, thus making silver worth more on the open market than as a currency. The U.S. continued efforts to maintain a bimetallic standard, but by 1873 it had adopted an unofficial gold standard.

1968 saw a surge in gold demand and resulted in a U.S. Congressional repeal of the requirement that Federal Reserves Notes be backed by gold. In 1971, President Richard Nixon said the U.S. would no longer convert dollars into gold at the official exchange rate. This was only supposed to be a temporary measure until the the U.S. dollar, in terms of gold, could be revalued. The U.S. dollar was losing value, and other countries didn’t want to hold U.S. dollars, but rather convert their dollars to gold. This ended up depleting U.S. gold reserves. In 1972, the U.S. dollar amount required to buy a troy ounce of gold was raised from $35 to $38. In 1973 it was raised to $42.22. The arrangement was still unfeasible as the U.S. would have needed to convert too many U.S. dollars into gold. The U.S. dollar became a free-floating currency. In 1975, gold began trading, for future delivery, on New York and Chicago exchanges.

The age of gold standard prominence has passed, although many counties still keep significant gold reserves including the U.S., France, Germany, Italy, China and Switzerland.

Gold and the U.S. Dollar

Gold and the US$ have always had an interesting relationship. Over the long term, a declining dollar generally means rising gold prices. In the short term, this is not always true, and the relationship can be tenuous at best, as the following one-year daily chart demonstrates. Notice the correlation indicator which moves from a strong negative correlation to a positive correlation and back again. The correlation is still biased toward the inverse (negative on the correlation study) though, so as the dollar rises gold typically declines.

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